Joint pricing-procurement control under fluctuating raw material costs

Abstract

We consider a firm that periodically procures raw material units, stores them, and processes them into finished products upon order arrivals. The raw material cost evolves in a Markovian fashion, whereas the demand process is influenced by both the raw material cost and sales prices charged by the firm. The firm controls both the raw material procurement activity and sales price in each period. We show the optimality of base-stock-list-price type of policies with the additional raw-cost dependence. Under conditions that are verifiable when the firm engages in price competition with other firms tapping into the same raw material market and when the raw material cost process has time-continuity and mean-reversion tendencies, we identify two monotone patterns in which policy parameters should follow as the raw material cost fluctuates. Cost increases are also shown to translate into price increases at low inventory levels. In other circumstances, however, there does not appear to be a clear pattern as to how the firm should pass cost increases on to end customers. Our numerical evidence unequivocally supports the adaptation of procurement and pricing controls to changing raw material costs.